Good Morning Hank,
I was reading this article from Morningstar and they said in it: “Mutual funds are required by law to pass along any income and capital gains they’ve earned throughout the year. These distributions typically take place near year end, and they can cause a tax headache if you’re not careful. (Dividend income and long-term capital gains are taxed at a 15% rate, while bond income and short-term capital gains are taxed at your highest marginal tax rate.”
Everyone talks about their ‘taxable or non-taxable’ accounts and the tax efficiency. What’s the difference? How do I know? Is my 401k taxable? -Amanda from Nashville
Nice question, but it is a bit trickier than that. All accounts are “taxable” to an extent. Your 401k WILL be taxed when you take it out; so to that extend, yes, it is taxable. But as far as your YEARLY taxes are concerned, you can put whatever you’d like (or have the option to like as per your company retirement plan) in that account through your company without tax consequence. It is growing tax deffered, so it would be considered a NON-taxable account as far as yearly taxes are concerned.
The best way to simplify it is to think taxable (brokerage account) vs. NON-taxable (retirement accounts). Your IRA and 401k plans grow without Uncle Sam dipping his paws in. In the case of the ROTH IRA, Sam already dipped as you’re using after tax dollars to fund it (but you get to take it out without Uncle Sams hands either). A regular brokerage account would hold any stocks or funds that were invested outside of your retirement accounts, with after tax money; generally, ANYTHING outside of retirement accounts (401k, 403b, IRAs, etc) are considered taxable. Check out MyMoneyBlog’s post about the efficiency of funds for a better clarification of the funds OUTSIDE your 401k.
in reference to your quote from Morningstar, the mutual fund IS required to pass along incomes they’ve received through the year (dividends) – So if you have that fund in your 401k or ROTH, don’t worry about it; it is likely getting rolled back in the account. However if you have it OUTSIDE your retirement package, just through a brokerage, you’re going to have to pay on those taxes to Uncle Sam. That’s why the article says they can cause a tax headache. Check with your financial advisor if you don’t know if you’re going to get hit with a larger than average tax bill for the funds you’re in OUTSIDE of retirement.
Hope that clears it up a little! Let me know if not!